Plan for the Channel to Break

Keep an eye on the S&P for a break under 1540

When the market starts to channel at a top, it’s not uncommon to see very unusual volatility and reactions to news that seems counterintuitive. That can include yesterday’s flash crash-type selling following a fake tweet about the White House being attacked to buying in front of bad news. A consolidation and channel at the top is the norm, and erratic volatility is typical in this situation.

Most market tops are usually comprised of a small channel. They last from 6-12 weeks on average and often are completed in the form of a major reversal pattern. The top in September 2012 was a “triple top,” while the May 2012 decline was preceded by a “head and shoulders” pattern. Both reversals took a little longer than two months to form and complete. The very large 2011 decline and the 2008 bear market were also both preceded by multi-month head-and-shoulders patterns.

So far, we can see the potential for another head-and-shoulders pattern, but it has not completed yet. Channels are important because they help traders monitor changes in capital flow in the market. For example, early breakouts in higher-risk sectors provide confirmation that the broader indexes are likely to follow. However, a consolidation is not a guarantee that prices will in fact fall — it’s merely a tool to plan for the potential decline.

S&P 500 Potential Head and Shoulders: Chart Courtesy of MetaStock Professional

Let’s assume that prices start to fall again this week and are finally able to cross below the current neckline support at 1540 on the S&P 500. The measure rule would predict a potential target of 1475-1495 to the downside on such a break. You can see what that looks like in the chart above. It’s important to remember that a break has not occurred yet but being prepared for one is wise.

In the meantime, although we know that a channel can last for 2-3 months, the trading range in such channels tends to be very tight. The average short-term channel (like this one) ranges 40-60 points, which on the S&P 500 sounds like a lot, but that is really only a robust week’s worth of a trend. In addition, there can be a great deal of counter-trend trading in individual equities. This makes trading a little trickier because reversals are so common. On the bright side, it also means break outs tend to be larger than they would be in a strong uptrend.

For option traders, this changes our risk profile a little. Trades should be kept short-term to avoid time value erosion, which can become a big issue. The probability of winning trades dips as well because of unexpected reversals, but the potential for big winners also increases on larger-than-average breakouts. This means risk control is critical and position sizing is an important component of that part of our trading strategy. We often suggest a size equal to 4% or less of the total amount available for option trading as an appropriate allocation.

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